Burger King is too big to fix

McDonald’s has a market capitalization of $100 billion for a reason. With the exception of a few years in the early 2000’s, McDonald’s executives have been very good stewards of their shareholders’ capital. Sadly, the same cannot be said for Burger King’s leadership over the past 10 years and the latest developments will do little, in our view, to enhance the company’s reputation.

The Burger King brand has been a cash cow that has lined the coffers of several different firms such as Pillsbury, Grand Met, and Diageo from 1989 through 2002. Private equity firm TPG Capital and others got in on the act from 2002 through 2006. From 2006 through 2010, PE firms tried to cash out while the company was public but, ultimately, the chain failed to gain fundamental momentum and 3G Capital took it over.

Now, 3G plans to list Burger King on the New York Stock Exchange, in a complex deal that will result in the private equity firm owning 71% of Burger King with the rest owned by Justice Holdings, a special purpose acquisition company owned in part by financier Bill Ackman and his hedge fund, Pershing Square Capital.

Our view is that the overriding motivation of several owners throughout the years, and now 3G Capital, has been to starve the brand of capital in order to pay parent shareholders nice and quickly. Burger King’s issues may be so substantial that the chain may be “too big to fix”, at least in the near term. By our reckoning, the last two private equity firms that have taken ownership of the company have deprived it of $1 billion or more in capital that could have been used to improve the company’s relative standing versus its competitors, many of whom Burger King now struggles to keep up with.

The least favorable comparison for Burger King is McDonald’s. Between 2002 and 2011, McDonald’s MCD has spent between $5 billion and $6 billion in capital expenditures on its U.S. business alone. While McDonald’s system is still in the process of being upgraded and does include some stores in need of remodeling, a plan is in place and the system has not been starved of capital as Burger King’s has.

However, despite the continuous issues that have dogged the chain, its owners of 18 months have claimed that Burger King is back. Somehow, having invested no capital into fixing the business, its problems have been resolved.

Ask yourself how many of your own problems you’ve solved by ignoring them. Not many. Not only has 3G Capital not invested any capital in the company, it sucked $295 million out of the business last year. The evidence for the company being back, in terms of its fundamental performance, is four months of positive same-store sales during the most favorable weather the restaurant industry has seen in years. Before this recent period, comps were negative for three years.

There are very few industries that are more competitive than the quick service segment of the restaurant industry. Consumer tastes are constantly changing and barriers to entry are low. The dramatic changes that have taken place within the industry over the past ten years underscore that point. The bar has been risen in terms of the consumer experience at every stage of the process; Chipotle’s CMG “assembly-line” ordering, Starbucks’ SBUX look and feel, and Domino’s online ordering experience are three examples of companies making the necessary investment to capture share.

Burger King has done none of that and is facing a difficult reality in this new world. As consumers demand higher standards, Burger King is going to have to invest billions of dollars in capital over a period of years to get its brand perception to where it needs to be.

We have to give credit where it is due – Bill Ackman is going to make money on this deal. But as independent observers, we have to wonder what happens after his payday. It’s worth bearing in mind the factors driving the decision of Justice Holdings to make this transaction. Having been public for over a year, the company – as a SPAC – was compelled to complete a transaction by February 2014. We think Justice Holdings saw in Burger King the same attributes that many PE investors have seen in the past: BK is a tried and tested cash machine and it fits the bill perfectly for Justice Holdings.

Looking at valuation levels of peer companies that could accurately be labeled as “brand royalty”, it makes sense for a deal to be done now. We believe that the success of the Dunkin’ Donuts DNKN IPO last summer – for the insiders and others that got a piece of the deal – is the biggest driver behind the timing of the Burger King deal.

But the current strategy does not seem to be focused on investing in the brand. The program to remodel restaurants is not yet being embraced by the franchisee base. If the current strategy fails, the question is whether that could be a death knell for the Burger King brand? We don’t think that’s as dramatic as some might believe. Our best guess at this point is that Burger King may be better off shrinking in order to grow. As it currently exists, the turnaround may be too great a task. Closing underperforming stores and bringing the average unit volume higher may be a good first step on the road to recovery.

CAPITAL DRAIN: In April 2011, BK issued $685 million of notes, yielding $401.5 million of proceeds, of which $294 million was returned to 3G in the form of a dividend.

BRAIN DRAIN: Last year, management gutted the company of $107 million in administrative expenses and cut head count by 40%, taking EBITDA up 50% but various one-time adjustments have to be made to get there.

ROYALTY STREAM/REMODEL PROGRAM: The company has reduced store ownership by 3%, reducing the need for capital spending. Unfortunately, 85% of the franchisee-base (measured in stores) has not bought into the remodel program thus far.

NEW MENU INITIATIVES: BK is introducing a new menu that is defensive and looks just like products that McDonald’s is selling.

POSITIVE SAME-STORE SALES: On the back of an extra trading day in February and the warmest winter in generations, the chain is seeing four months of positive SSS after three years of declines

THE BRAZILIAN CONNECTION: The presence of Brazilian management professionals on the team somehow lends credence to the notion that BK could have more stores than MCD in Brazil?

DOMESTIC QSR GROWTH: The QSR market in the USA is growing? That may be true but that growth is not coming from tired old chains like Burger King. Quick casual is the growth engine of QSR.

IMPROVED FRANCHISEE RELATIONS: The franchisees apparently like the new management team but, at the same time, the new owners did not exactly take care of franchisees in 20 states with the recent refranchising deal by Carol Restaurant Group TAST.

STRONG MANAGEMENT: Despite this claim, we are unsure that the team outlined in Ackman’s presentation is best-equipped to overcome the challenges BK faces, particularly in the uber-competitive U.S. market

THE ART OF A DEAL: The fact that Bill Ackman gave the presentation on behalf of a company does not bode well for the storytelling capabilities of BK’s team. They will need to hone those skills rapidly over the coming months!